The Gap stumbles on downgrade

Sluggish sales trends worry Merrill Lynch

By

SusanLerner

SAN FRANCISCO (CBS.MW) -- Concerned that The Gap may be facing a cool fall, Merrill Lynch cut its rating on the apparel retailer Wednesday.

Analyst Mark Friedman told clients that he fears sluggish sales trends may continue over the last weekend of summer and throughout the fall, so he downgraded the company's stock
GPS, -0.18%
to "neutral" from "buy," while lowering his future estimates.

Gap shares closed down 40 cents, or 2 percent, at $19.52.

"The Gap is a destination, but the stores right now look somewhat uninspired," Friedman wrote in a research note.

After a strong spring and a good start to summer, the analyst said that the retailer's sales have struggled in recent months, reflecting fewer markdowns, more restrained consumer spending in the smaller June/July sales months and less impressive product offerings.

"There have been some hits, but relative to what we have seen in the past when Gap gets it, this is not a blowout assortment," Friedman added.

He believes the so-called bottoms business remains solid and some core elements are selling, but that the color story was not as strong as he would like.

"While true fall has not yet set, what we have seen thus far is good, not great," Friedman said.

For 2004, he took his earnings estimates down to $1.29 a share from $1.32 and his 2005 forecast to $1.60 a share from $1.62.

In addition to product issues, the Gap is also facing uncertainty from a shift in focus to "wardrobing," which targets older customers, rather than back-to-school kids.

"The risk is that it may take a bit longer to gain traction with this consumer," he added.

Margin call

Given the issues at Gap stores, Friedman thinks the rest of the company would have to perform "at top levels" to achieve upside to his estimates.

The analyst said, however, that one area that remains intact is the retailer's margins. He expects 2004 operating margins of 13.1 percent and a return to peak levels over the next few years. Gap, he added, achieved peak operating margins of 15.6 percent in 1999.

"The company today is already greatly improved operationally and as it relates to inventory management," Friedman elaborated, saying that the Gap remains focused on initiatives that, in conjunction with better sales, should help margins.

Some of these initiatives include an emphasis on improved inventory management, more efficient distribution to its stores, systems upgrades and flow strategies.

"Although the timing of the impact and the magnitude of these strategies are difficult to determine, we believe the success is already evident and will continue to drive operational and thus earnings improvement," Friedman wrote.

Still, the company is approaching a difficult time. "Unlike the first five months where spending and trends were outstanding, the risk of slowing consumer spending and tough compares in the back half leaves less room for error," he said.

In addition, other initiatives to drive stock excitement, such as additional growth vehicles and share buybacks, may not be committed to until 2005.

Yet there were a couple of wild cards to the Gap story, according to the Merrill analyst.

The most immediate, he believes, is the potential impact of a new ad campaign featuring Sarah Jessica Parker.

"While we do not believe this campaign will set off a sudden wave of hipness and thus necessity for customers to flock to the store, we could be wrong," he said.

Friedman added that the other risk to his downgrade is the possibility that the company pulls off an "outstanding" holiday season after the fall, though he cautioned that it was still too early to make a call on the holiday season.

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